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DETERMINANTS OF DEBT CAPACITY 1st set of transparencies for ToCF

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DETERMINANTS OF DEBT CAPACITY

1st set of transparencies for ToCF

INTRODUCTION

INTRODUCTION

I.

I.

Adam Smith (1776) - Berle-Means (1932)

Agency problem

Principal

outsiders/investors/lenders

Agent

insiders/managers/entrepreneur

1. Insufficient ‘‘effort’’

2. Inefficient investment

3. Entrenchment strategies

4. Private benefits

Good governance:(1) selects most able managers

(2) makes them accountable to investors

2. Inefficient investment

Pet projects.

Empire building.

OUTLINE

Approach: controlled experiment

Topics:

- 1. Micro
- Basics:(a)one-stage financing: fixed and variable investment models;
- (b)applications: debt overhang, diversification, collateral pledging, redeployability of assets.
- Multistage financing: liquidity ratios, soft budget constraint, free cash flow.
- Financing under asymmetric information.
- Exit and voice in corporate governance.
- Control rights.

- 2. Macro
- Dual role of assets and multiple equilibria.
- Credit crunch.
- Liquidity shortages.
- Liquidity premia and pricing of assets.
- Political economy of corporate finance.

II.

BASICS OF CREDIT RATIONING: FIXED INVESTMENT MODEL

Lenders / investors /outsiders

Project costs I.

Has cash A < I.

Entrepreneur / borrower / insider

Key question: Can lenders recoup their investment?

TYPICAL MODEL

• Risk neutral entrepreneur has one project, needs outside financing.

Want to induce good behavior:

and

Contract: Success:

Rb + R =R.

Failure: 0 each (optimal).

Reward Rb in case of success

Necessary and sufficient condition for financing

or

PLEDGEABLE INCOME INVESTORS’ OUTLAY

Minimum equity:

Remarks

(1) Entrepreneur receives NPV

Will always be the case with competitive financial market.

(2) Reputational capital / scope for diversion (shortcut)

A increases with B.

Note : Courts can help reduce B

(3) Investors’ claim: debt or equity?

(At least) two interpretations:

- inside equity + outside debt (R to be reimbursed);

- all-equity firm: shares

No longer true if leftover value in case of failure. In any case: no need for multiple outside claims.

weakness,

strength (focus on fundamentals).

DEBT OVERHANG

Definition:(project would always be financed inabsence of previous claim).

Example:

A < 0new investment cannot be financedsolely because renegotiation with initialinvestors infeasible.

Previous claim is senior.

Borrower no longer has cash (A =0).

a) Bargaining with initial investors, who have cash

Noone receives anything if no investment.

Investment: Choose Rbsuch that

and

Feasible since

b)Initial investors don’t have funds to invest. Bargainingwith new investors only.

Income that can be pledged to new investors:

by assumption.

cannot raise funds.

DEBT OVERHANG

c)Initial investors don’t have funds to invest. Bargainingwith new and initial investors.

Debt forgiveness: where

That is

When is debt overhang an issue?

– Many creditors. Examples:

- corporate bonds
- (nomination of bond trustee, exchange offers)

- interbank market/derivatives/guarantees,..

– Asymmetric information (not in this model).

III.

BASICS OF CREDIT RATIONING/VARIABLE INVESTMENT MODEL

1. EQUITY MULTIPLIER / DEBT CAPACITY

Implicit (perfect) correlation hypothesis: specialization,voluntary correlation, macro shocks.

Notation:

income per unit of investment

pledgeable income per unit of investment

Assumption

First inequality: finite investment

Second inequality: positive NPV (otherwise no investment).

Constraints:

and

Borrower’s utility (=NPV)

wants to maximize I.

DEBT CAPACITY

Utility

DEBT OR EQUITY? THE MAXIMAL INCENTIVE PRINCIPLE

Extension: RSI in case of success

RFI in case of failure (salvagevalue of assets)

Generalization of

Optimal sharing rule:

s.t.

and

Breakeven constraint binding (otherwise ).

wants to maximize I.

Incentive constraint binding (otherwise debt capacity)

Suppose Then

relaxes incentive constraint.

Outside debt maximizes inside incentives

Generalization: Innes (1990).

Discussion:

- risk taking,
- broader notion of insiders,
- risk aversion.

2. DIVERSIFICATION

Diamond (1984)’s diversification argument.

n projects.

IRS due to the possibility of cross-pledging.

Basic idea:

TWO IDENTICAL PROJECTS

Rewards R0 , R1 , R2

Risk neutrality R0 = R1 =0.

Other IC constraint is then satisfied

Nonpledgeable income

Financing condition. Entrepreneur’s equity= 2A.

PROJECT FINANCE IS NOT OPTIMAL

Continuum of independent projects

Two cases: pHR - B - I < 0 : net worth still plays a role

pHR - B - I > 0 : unlimited size

Second case: continuum of projects, mass 1.

Debt contract: D=I

Work on all: pHR - D = pHR- I > 0

Work on y % of the projects:

either y pH R + (1-y) pLR < I then y=0 better, but dominated

or y pH R + (1-y) pLR I

payoff increases with y ((p )R > B)

LIMITS TO DIVERSIFICATION

• limited attention,

• core competency,

• endogenous correlation (asset substitution, VaR)

continuum:

3. LIQUIDITY NEEDS

In case of "liquidity shock", rbinvested yields : rb> rbto

entrepreneur (none of which is pledgeable to investors).

Two issues:

• imperfect performance measurement at date 1

• strategic exit (if liquidity shock unobservable, 2 dimensions of MH: effort, truthful announcement of liquidity need).

Contract (can show: no loss of generality)

Menu:

• Rbin case of success at date 2, or

• rbat date 1.

Benchmark: Liquidity shock observable

or

Independent of rb!

Pledgeable income (for given rb) :

Must exceed I-A rbcannot be too large!

Case 2: Possibility of strategic exit

Assume pL=0 (or, more generally, small) wants to exit if shirks.

or

pL = 0 (2) is more constraining than (1).

Must also have

Pledgeable income: (for given rb)

when rb >0. And:

Lower pledgeable income, same NPV. *

* for a given rb. But rbis smaller!

Benefit from speculative monitoring at date 1.

Signal: good or bad. Good signal has probability qHor qL.

Incentive constraint:

Disciplines entrepreneur.

- Same if active monitor as well.
- In practice
- – sale to a buyer,
- – IPO.

VC exit is carefully planned.

- Reversed pecking-order logic: want risky claim to encourage speculative monitoring.

4. COLLATERAL / REDEPLOYABILITY OF ASSETS

- Pledging collateral:–increases pledgeable income,
- – boosts incentives if state-contingent pledges.

- Cost of collateralization:– transaction cost,
– suboptimal maintenance,

– lower value for lender.

- Redeployability of assets boosts debt capacity

Proper credit analysis:

relevant value of collateral average value:

– low maintenance near distress,

– aggregate shocks.

Assumption: 0 P 1

Previously: x = 1.

- Positive NPV:

- Breakeven condition:

I grows with P.

(grows with P, for two reasons).

5. ENDOGENEIZATION OF P: SHLEIFER-VISHNY (1992)

(chapter 14 in book)

Idea : P endogenous, depends on existence of other firms able to purchase asset.

Model : 2 firms in industry (do not compete on product market). "Local liquidity": only other firm can buy asset.

Entrepreneur i : cash Ai, borrows Ii -Ai.

If j in distress and i not in distress, i (with the help of lender i) can buy j’s assets.

assets I1+I2

potential private benefit B(I1 + I2)

income in case of success R(I1 + I2)

As usual

and

Lender i and entrepreneur i sign (secret) loan agreement {Ii , Rbi},

LIQUIDATION VALUES

Both firms in distress: no revenue for anyone.

None in distress: standard model.

Firm 1 in distress, firm 2 is not:

Assumption: lender 1 makes take-it-or-leave-it offer to lender 2.

Lender 2 must adjust incentive scheme:

becomes

Discount since 0 < 1.

Extra rent for entrepreneur 2:

Entrepreneur’s expected utility:

where

and

Debt capacity decreases with correlation between shocks.

Ii = kAi where

Ii 1(minimum scale) and < 0

multiple equilibria (complementarity).

- Financial muscle: do potential acquirers build too much or too little financial muscle for M & As? See chapter 14.